Level III Review | Asset Allocation

Study session eight in the Level III CFA Program curriculum includes two readings (21-22) in asset allocation. The material is often tested along with the individual and institutional questions in the essay section so make sure you understand the concepts well enough to synthesize the material.
Asset Allocation
A key focus of the CFA curriculum is based on strategic asset allocation, building a long-term mix of assets given the investor’s IPS and market expectations. Understand that tactical asset allocation is based on short-term expectations for relative performance among asset classes and does not change the long-term strategic mix.
The difference between asset-only and asset/liability management is an important one. ALM involves the explicit modeling of liabilities and adapting the asset allocation to meet these liabilities whereas asset-only is focused on meeting a total return target. ALM is usually more appropriate for some institutions (i.e. banks, insurance, and sometimes pensions) but may also be applied to individuals with extremely low risk tolerance and a stated desire to meet liabilities.
The five criteria for asset classes might be good for a random question and is fairly easy to memorize. The way I did it was to understand the concept for each and associate it with one word, then remember the first letter of each word (H-M-D-P-L) for easier recall.

  • Homogenous – similar attributes within a class
  • Mutually exclusive – overlapping assets will blur the effectiveness of the process
  • Diversifying – important for risk management and correlations
  • Preponderance of world investable wealth – important in developing the risk/return tradeoff
  • Liquidity- to avoid high transaction costs and the ability to rebalance when needed

Understand what makes alternative investments different (i.e. liquidity, information asymmetry, higher cost of investment)
Understand the concepts as well as strength/limitation behind the different approaches: mean-variance, resampled efficient frontier, Black Litterman, Monte Carlo simulation, ALM, and experience-based.
The material tying individual and the specific institutional investors to asset allocation is often tested in the morning section. Make sure you know the differences (needs) across each and look through the old exams to see how it is tested.
The Case for International Diversification
This is largely a conceptual reading so just focus on getting the idea. Calculating the currency return and the investment return, as well as the currency contribution to risk is easily testable.
Understand the reasons economies may move independently: government regulation, technological specialization, fiscal and monetary policy, cultural or sociological differences.
Understand the reasons against international diversification: increasing correlations over time, increasing correlations in times of higher volatility, free trade, integrated capital markets, mobility of capital, multi-national corporations.
Understand the hurdles to investing internationally: transaction costs, regulations, taxes, currency risk, political risk, lack of familiarity, and information asymmetry.
Study session nine covers two readings in fixed income. The topic counts towards 10%-20% of your exam so be prepared to spend some time.
‘til next time, happy studyin’
Joseph Hogue, CFA

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